The Next Big Short

If you have forgotten your Gulliver’s Travels, recall that Jonathan Swift described the people of Brobdingnag as being as tall as church steeples and having a ten foot stride. Everything else was in proportion - with rats the size of mastiffs and the latter the size of four elephants, while flies were “as big as a Dunstable lark” and wasps were the size of partridges.

Hence the word for this fictional land has come to mean colossal, enormous, gigantic, huge, immense or, as the urban dictionary puts it, “really f*cking big”.

That would also describe the $325 billion bubble which comprises Amazon’s market cap. It is at once brobdangnagian and preposterous - a trick on the casino signifying that the crowd has once again gone stark raving mad.

When you have arrived at a condition of extreme “irrational exuberance” there is probably no insult to ordinary valuation metrics that can shock. But for want of doubt consider that AMZN earned the grand sum of $79 million last quarter and $328 million for the LTM period ending in September.

That’s right. Its conventional PE multiple is 985X!

And, no, its not a biotech start-up in phase 3 FDA trials with a sure fire cancer cure set to be approved any day; its actually been around more than a quarter century, putting it in the oldest quartile of businesses in the US.

But according to the loony posse of sell-side apologists who cover the company——there are 15 buy recommendations—–Amazon is still furiously investing in “growth” after all of these years. So never mind the PE multiple; earnings are being temporarily sacrificed for growth.

Well, yes. On its approximate $100 billion in LTM sales Amazon did generate $32.6 billion of gross profit. But the great builder behind the curtain in Seattle choose to “reinvest” $5 billion in sales and marketing, $14 billion in general and administrative expense and $11.6 billion in R&D.

So there wasn’t much left for the bottom line, and not surprisingly. Amazon’s huge R&D expense alone was actually nearly three times higher than that of pharmaceutical giant Bristol-Myers Squibb. But apparently that’s why Bezos boldly bags the big valuation multiples.

Not so fast, we think. Is there any evidence that all this madcap “investment” in the upper lines of the P&L for all these years is showing signs of momentum in cash generation? After all, sooner or later valuation has to be about free cash flow, even if you set aside GAAP accounting income.

In fact, AMZN generated $9.8 billion in operating cash flow during its most recent LTM period and spent $7.0 billion on CapEx and other investments. So its modest $2.8 billion of free cash flow implies a multiple of 117X.

Needless to say, the sell side chorus insists that one doesn’t matter, either. At the drop of a hat Bezos could purportedly hit the investment “pause” bottom and unleash a surge of free cash flow.

The cynic might say good luck on that, considering the record. But then again, he might also ask why was Bezos’ pause button massively rerated upward just as this bull market was reaching its fevered peak?

That is, we are just completing a year in which the Fabulous Four FANG stocks (Facebook, Amazon, Netflix and Google) gained $500 billion of market cap while the remaining 496 companies in the S&P index went down by more than one-half trillion dollars.

In that context, AMZN’s market cap one year ago was just $145 billion, meaning that it gained a stunning $180 billion or 125 percent during the interim.

By contrast, its free cash flow for the year ended September 2014 was $2.3 billion, meaning not only that it grew by a modest amount, but that a year ago the so-called “market” was valuing AMZN at just 62X free cash flow. And to complete the picture, during the year ended in December 2011 Amazon generated $2.0 billion of free cash flow, meaning that is was then being valued at just 40X.

Can you say bubble mania? Bezos is surely the greatest empire builder since Genghis Kahn, and has never wavered in his determination to spend every dime the company generates in sales. Profits be damned.

But history will surely record that the 48 months since December 2011 comprised the final stages of the most stupendous financial bubble in recorded history. During that period, the casino re-rated Amazon’s meager free cash flow from 40X to 62X to 117Xon virtually no improvement in performance.

It was just plain old multiple inflation gone wild with respect to the last momo stocks standing.

We have been here before, and there is no better analogy than Cisco and its fellow shooting stars in early 2000 on the eve of the dotcom crash.

Indeed, Amazon’s $325 billion valuation is just plain irrational exuberance having one more fling. Spasms like this year $180 billion gain (125%) on the AMZN ticker or the $190 billion gain (55%) on the GOOG account are absolutely reminiscent of the final days before the tech wreck exactly 15 years ago.

In a recent post I demonstrated how the 12 Big Cap Techs of 2000—-led by Microsoft, Intel, Dell and Cisco——-saw their combined valuation soar from $900 billion to $3.8 trillion in the 48 months leading up to the March 2000 peak; and that they then plunged to just $875 billion a decade later.

To wit, their bubble era market cap got whacked by $3 trillion in the years ahead, even as their sales and earnings continued to grow. What got purged was irrational exuberance in a casino high on the central bank’s monetary heroin.

In this regard, Cisco was the poster child last time around for this kind of top-of-the-bubble disconnect. During the 48 month run to March 2000, its market cap had exploded from $40 billion to $506 billion or by nearly 13X.

By contrast, it net income had increased from $1.0 to $2.5 billion or by just 2.5X. Accordingly, its PE multiple was rerated during this classic era of irrational exuberance from 40X to 200X.

Even then, Cisco was not only the provider of all things for the internet, but was actually run by a CEO who had a decent respect for the idea of profits.

Indeed, during the most recent twelve months in the spring of 2000 CISCO had earned a respectable $2.5 billion of net income on $15 billion of sales. Moreover, this most recent net income posting had grown for eight straight years at a spectacular 50% compound rate from $100 million in 1992.

So its earnings track record was far more impressive and reliably rising than Amazon’s recent results. In fact, AMZN’s net income peaked at $1.15 billion way back in 2010 and has not come close to that high water mark since.

Still, Cisco’s problem at the turn of the century was the market’s lunatic valuation at 200X its smartly growing net income.

But here’s the thing. Cisco was already a mature technology company. There was no growth rate in the known universe that would have permitted it to earn into a $500 billion valuation.

Even at a standard 20X market multiple on its existing fulsome net margins (17%), it would have needed $25 billion of net income on $150 billion of sales to make valuation ends meet.

In fact, during the next 15 years Cisco’s performance steadily improved, but one and one-half decades later it is still at only one-third of the levels implied by its dotcom era market cap.That is, revenues have grown from $15 billion to nearly $50 billion, and its net income has more than tripled to nearly $10 billion per year.

Needless to say, it’s market cap today at $140 billion is just 25% of its dotcom bubble peak!

In short, its market cap was driven to the absurd height recorded in March 2000 by the final spasm of a bull market, when the punters jumped on the last momo trains out of the station.

At the end of the day, AMZN’s current preposterous $325 billion market cap has nothing to do with the business prospects of Amazon or the considerable entrepreneurial prowess of Jeff Bezos and his army of disrupters.

It is more in the nature of financial rigor mortis - the final spasm of the robo-traders and the fast money crowd chasing one of the greatest bubbles still standing in the casino.

And, yes, notwithstanding all the “good things it brings to life” daily, it is not the present day incarnation of even the mighty General Electric of the 1950s; and for one blindingly obvious reason. It has never made a profit beyond occasional quarterly chump change.

Not only has its net income been falling for five years, but what it has generated in the interim is actually a joke. To wit, during the last 23 quarters its has posted cumulative sales of nearly $380 billion but only $2 billion of net income and half of that was in 2010.

That’s right. The Kool Aid drinkers in the casino are betting $325 billion on a massive e-commerce distributor of books and merchandise that has a steady state profit rate at 0.5% of sales.

Admittedly, in these waning days of the third great central bank enabled bubble of this century, GAAP net income is a decidedly quaint concept. In the casino it’s all about beanstalks which grow to the sky and sell-side gobbledygook.

Next Steps For AWS… SaaS Applications? We believe AWS has an opportunity to move up the cloud stack to applications and leverage its existing base of AWS IaaS/PaaS 1M + users.

AWS dipped its toes into the SaaS pool earlier this year when it expanded its offerings to include an email management program and we believe it will continue to extend its expertise to other offerings. We do not believe that this optionality is baked into investors’ outlook for AWS.

Got that?

Instead, better try this. As indicated above, AMZN’s operating free cash flow during its most recent LTM period was $2.76 billion compared to $2.26 billion way back in 2009.

So its six year free cash flow growth rate computes to just 3.35% per annum. And on that going nowhere track record, AMZN is being valued at, well, like we said, 117X free cash flow!

The fact is, Amazon is one of the greatest cash burning machines ever invented. Its net revenues of just $8.5 billion in 2005 have since grown by 12X to $101 billion for the LTM period ending in September, meaning that during the last ten and three-fourths years it has booked $455 billion in sales. But its cumulative operating free cash flow over that same period was just $6 billion or 1.3% of its turnover.

So, no, Amazon is not a profit-making enterprise in any meaningful sense of the word and its stock price measures nothing more than the raging speculative juices in the casino.

In an honest free market, real investors would never give a $325 billion valuation to a business that refuses to make a profit, never pays a dividend and is a one-percenter at best in the free cash flow department—–that is, in the very thing that capitalist enterprises are born to produce.

Indeed, the Wall Street brokers’ explanation for AMZN’s $325 billion of bottled air is actually proof positive that the casino has become unhinged. For more than two decades, Amazon has been promoted as the monster of the E-commerce midway, which it surely is.

But this year’s $180 billion roll of the dice has absolutely nothing to do with its capacity for same day delivery of healthy treats for your pooch. This most recent rip was all about the purportedly “scorching” performance of its AWS division——-that is, Amazon’s totally unrelated business as a vendor of cloud computing services.

Indeed, CNBC recently gave air time to one of the most rabid analyst on the block, and this particular stock peddler from UBS left nothing to the imagination. Never mind whether anything emanating from that serial swindler and confessed criminal organization can be taken seriously, here’s what the man said.

AWS is technology’s second coming and is worth $110 billion. We know that because AMZN has recently been thoughtful enough to break out its financials.

They show AWS had sales of $2.1 billion in the September quarter and revenues of $7 billion on an LTM basis. So that puts its cloud computing business’ value at 16X sales. No sweat!

Moreover, this means that the balance of the company—–that is, its core E-commerce business—– is “only” valued at an apparently much more reasonable $215 billion. And by golly, said the UBS man, that’s just 1.4X sales. So what’s not to like?

Well, hold it right there. Someone forgot to do the math in all the excitement about AWS. Yes, the company’s release did show that AWS posted $1.33 billion of operating income or about 20% of sales in the during the LTM period.

But consolidated operating income during the quarter was only $1.72 billion, meaning that by the lights of subtraction, Jeff Bezos’ great empire of E-commerce earned the microscopic sum of $390 million in operating income during its most recent year.

By the same magic of subtraction we can see that AMZN’s E-commerce business generated $94 billion of sales. This means that its operating margin was exactly 40 basis points.

That’s right—–after 25 years of crushing it on the E-commerce front, Amazon’s core business operating margin is truly a rounding error.

And might we also ask why you would value at $215 billion the profitless sales of an E-commerce monster that just can’t stop spending every dime it takes-in on distribution centers, package handlers, hired delivery trucks and drone prototypes; and now, apparently, same hour delivery service by out-of-work actors and bank tellers who happen to own a Vespa!

Stated differently, AMZN’s $180 billion market cap gain in 2015 was not actually a re-rating; it was a bait-and-switch operation by the high-rollers in the casino.

Amazon is not the inventor and first-mover of E-commerce, after all. Instead, it’s now suddenly held to be the monster of the midway in the totally unrelated business of cloud computing services.

By the lights of the UBS man and Wall Street’s amen chorus, AWS is valued at 16X sales now. But it will surely crush any competitor in the stretch ahead, and thereby grow its way into that outsized valuation.

Except don’t tell Google, Microsoft, Oracle or several others about the beanstalk thing. Indeed, the current nattering about AWS was truly ridiculous. Why would anyone endowed with a modicum of sanity believe that these tech powerhouses are about to cede the cloud to Amazon merely because it comes first in the alphabet?

There is no other real reason for thinking so. Between them, the big three mentioned above have about $220 billion of cash and deep franchises in the world of computing and the internet.

Sure, when technology moved from owned boxes, corporate computer centers and software licenses to a rent-a-server model, Amazon got out of the gate first because it had no installed base of old technology to protect.

But there are no barriers to entry, no killer patents, no material brand equity, no irreproducible sales and service network etc. that will permit Amazon to ring-fence the cloud. So there will be viscous competition and prices will fall at a rate which will make Moore’s law look tepid.

Indeed, Larry Ellison has recently promised to cut prices by 90%, and he has rarely failed to follow through on exactly that kind of competitive rampage.

Likewise, it would appear that the cloud is destined to be the future home of Microsoft’s entire franchise. Surely it is probable that AMZN’s Seattle neighbor can make the transition from selling computer software to renting cloud services.

In short, AMZN has disclosed almost nothing about AWS’s detailed business model, its fixed and variable cost structure or the investment requirements of its rentable clouds and the rates of return on the massive amounts of capital employed.

Only the Wall Street boys, girls and robo-traders betting on red could come up with $110 billion valuation of a nascent business that is positioned in the cross-fire of the Big Tech battlefield.

So Amazon’s total $325 billion valuation is just plain irrational exuberance. It is also surely the short of a lifetime.